Top 10 Business Valuation Mistakes

Article Author: Garry Stephensen
Position: Managing Director
Read time: 6 mins

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As a business owner the business valuation process seems like a big black box. You insert lots of information into it and several weeks later you get a very thick and confusing report that tells you how much your business is worth. The problem is you don't understand the process or the report and don't know how to evaluate either. When reading the report, look for these common business valuation mistakes.

Mistake #1 – Unqualified Appraiser

The most common problem with business valuation reports is that they have been prepared by someone who is unqualified. There is little, if any, regulation of the business valuation industry and it is often difficult to find firms that offer business valuation services. People tend to hire the first firm they find or their current accountant/tax preparer. Not all CPAs are competent in business valuation. In fact, many CPAs have very little or no business valuation experience or training.

Look for professionals that have at least one of the following major business valuation designations by searching their online directories.

• Accredited in Business Valuation (ABV) - www.aicpa.org/credentialsrefweb/ABVCredentialSearchPage.aspx

• Accredited Senior Appraiser in Business Valuation (ASA-BV) - www.bvappraisers.org/find/

• Certified Business Appraiser (CBA) - www.go-iba.org/directory.htm

• Certified Valuation Analyst (CVA) - www.nacva.com/dir/

Mistake #2 – Not Objective

In the course of performing a valuation many judgment calls are made, so the independence and objectivity of the appraiser are critical to producing a credible result. A CPA firm that has a long, established history with the company being appraised is generally not considered independent.

Mistake #3 – Uses Rule of Thumb Formulas

Industry rules of thumb can be useful to get a "quick and dirty" estimate, but they have some serious flaws. No one really knows the quality and the quantity of the data on which they are based. The formulas typically use multiples that are expressed in ranges (like 1 to 2 times annual sales) that result in widely varying values.

Mistake #4 – Values Future Potential

A fundamental rule I learned from business brokerage is – never, ever pay for potential. Developing potential requires an investment of time, effort and money, and also involves risk. Undeveloped potential has no value.

Mistake #5 – Uses an Arbitrary Multiple or Rate

Many valuation methods call for applying some type of multiple to company financial data. These multiples are a critical component in determining value. Yet, they often appear with little or no explanation of how they were determined and why they are appropriate.

Mistake #6 – Uses Only One Valuation Method

There are many ways to value a business. A valuation that uses only one method is suspect. Best practices require that all three valuation approaches (market, income, and asset/cost) be considered.

Mistake #7 – Does Not Define If Assets or Stock is Being Appraised

Companies can be sold in two basic ways – asset or stock sales. An asset sale is the most common type of transaction. Asset sales typically include only the inventory, equipment and intangible assets (goodwill) of a business. A stock sale is a sale of the entire entity and includes all its assets and liabilities. Most valuations estimate the value of a company at the entity level, but the valuation report should clearly identify what property is being valued.

Mistake #8 – Counts the Value of Intangibles Twice

It is tempting to adjust the value of a company for intangibles like: name recognition, loyal customer base, a great location, etc. The company benefits from these intangibles through higher sales and improved cash flow. Therefore, valuation methods based on sales or cash flow already account for these intangibles. They should not be counted twice.

Need advice with your business sale? Contact our Melbourne Business Brokers, Sydney Business Brokers or Brisbane Business Brokers.

Mistake #9 – Does Not Define Whose Perspective is Being Used

The value of anything depends on whose perspective is used to determine it. The standard of value defines the perspective used in a valuation. The most common standard of value is fair market value which is based on the perspective of a hypothetical sale of the company from a hypothetical seller to a hypothetical buyer. Hypothetical is generally defined as the most-likely.

Mistake #10 – Uses Valuation Methods or Data That Don't Match

The value of a business interest is based on two criteria – marketability and control. The valuation method and data used must match the type of business interest being valued. A share of stock of a publicly traded company does not control the company and is easily sold. A 100 percent interest in a privately held business does control the business and is not easily sold. Data from public companies cannot be used to value a privately held business without being adjusted to compensate for the differences.

Conclusion

Business valuation is a complicated process. Now, you can look for these common mistakes to help you evaluate those thick and confusing valuation reports.

Source David Coffman CPA/ABV

How To Prepare For A Business Valuation

Preparing for a business valuation is a critical step for any business owner looking to sell their business, attract investors, or understand their company's worth. A thorough preparation can significantly influence the valuation outcome, ensuring it reflects the true value of the business. Here is a comprehensive guide to help business owners get ready for a valuation.

Organizing Financial Records

1. Gather Financial Statements:

   • Collect and organize all financial statements for at least the past five years. This includes income statements, balance sheets, and cash flow statements. Ensure these documents are accurate and up to date, as they form the backbone of the valuation process.

2. Reconcile Bank Statements:

   • Make sure your bank statements reconcile with your financial statements. Discrepancies can raise red flags for appraisers and undermine the credibility of your financial records.

3. Tax Returns:

   • Prepare copies of your business tax returns for the last five years. Tax returns provide an external verification of your financial statements and are crucial for validating reported earnings.

4. Accounts Receivable and Payable:

   • Detail your accounts receivable and accounts payable. Highlight aging reports to show the payment history of your customers and the business's creditworthiness.

5. Expense Documentation:

   • Document all expenses meticulously. Break down operational, administrative, and discretionary expenses. Providing a clear picture of your cost structure helps the appraiser understand your profit margins and operational efficiency.

Understanding Key Value Drivers

1. Revenue Streams:

   • Identify and document all revenue streams. Explain how each stream contributes to the overall revenue, highlighting any recurring or contractual income, which is particularly attractive to buyers and investors.

2. Customer Base:

   • Provide details about your customer base, including the number of customers, customer concentration (i.e., how much revenue comes from your top customers), and customer loyalty. A diversified and loyal customer base can significantly enhance business value.

3. Market Position and Competitive Advantage:

   • Describe your market position and competitive advantages. This can include proprietary technology, brand reputation, exclusive contracts, or unique business processes that set your company apart from competitors.

4. Growth Prospects:

   • Outline your growth prospects. Include market trends, expansion opportunities, and strategies for scaling the business. Demonstrating potential for future growth can positively impact the valuation.

5. Management Team:

   • Highlight the strengths of your management team. A capable and experienced management team can reassure appraisers of the business's ability to maintain performance and grow.

6. Operational Efficiency:

   • Show evidence of operational efficiency. Provide data on production costs, inventory management, and any implemented improvements or efficiencies that enhance profitability.

Preparing for the Appraiser's Questions

1. Detailed Business Plan:

   • Prepare a detailed business plan that includes your business model, market analysis, marketing strategy, financial projections, and risk management plans. A well-crafted business plan shows that you have a clear vision and strategy for the future.

2. Risk Factors:

   • Be ready to discuss risk factors affecting your business. These can include market risks, operational risks, regulatory risks, and any recent industry developments. Addressing risks proactively demonstrates awareness and preparedness.

3. Asset Documentation:

   • Document all physical and intangible assets. This includes real estate, equipment, intellectual property, and any proprietary software. Ensure all assets are accounted for and valued correctly.

4. Employee Information:

   • Provide detailed information about your workforce. Include employee numbers, roles, tenure, and any key personnel critical to the business operations. Highlight any labor agreements or outstanding employment-related obligations.

5. Legal Matters:

   • Be transparent about any ongoing or past legal matters. This includes lawsuits, compliance issues, and any other legal disputes. Legal clarity can affect the risk assessment of the business.

6. Historical Performance Analysis:

   • Be prepared to discuss your business's historical performance. Explain any significant fluctuations in revenue, expenses, or profitability. Appraisers will want to understand the reasons behind these changes to gauge future performance.

Streamlining the Process

1. Use Professional Services:

   • Consider hiring an accountant or financial advisor to help prepare your financial records and ensure they are in order. Professionals can also assist in presenting your business in the best light.

2. Digital Organization:

   • Digitize all important documents and maintain an organized digital archive. This makes it easier to access and share documents with the appraiser, speeding up the valuation process.

3. Regular Updates:

   • Keep your records regularly updated. Don't wait until a valuation is imminent to organize your documents. Regular updates ensure that you are always prepared for a valuation or any due diligence process.

4. Mock Valuation:

   • Conduct a mock valuation with the help of a financial advisor. This can identify potential issues and areas of improvement before the actual valuation, giving you time to address them.

Conclusion

Preparing for a business valuation involves meticulous organization and a deep understanding of your business's key value drivers. By maintaining accurate financial records, understanding what makes your business valuable, and preparing thoroughly for the appraiser's questions, you can ensure that your business is valued accurately and favorably. This preparation not only aids in achieving a higher valuation but also provides valuable insights into your business's performance and potential for future growth. Whether you are planning to sell, attract investors, or simply understand your business's worth, these actionable steps will position you for success in the valuation process.

Garry
Managing Director

Karen
Director NSW

Geoffrey
Lloyds Corporate Partner - Mergers & Acquisition Specialist

Edward
Director Victoria

Dianne
Research Director and Corporate Broker

Rudolf
Lloyds Corporate Brokers - Foundation Director

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